What Is An Efficient Capital Market?

Summary:The allocation of capital is the spring from which
all investment flows. Understanding the workings of an efficient
capital market and why companies will always be raising capital from
stock market instruments is vital to any investor. This page will
hopefully start that understanding...

Entrepreneurs and companies - both large and small - will always
have needs for money. This may be to further develop an idea or
invention, to expand a business, to buy another business or for cash
flow requirements.

In the very early days of a stock market, there was a physical
location (long before computers or telephones) where individuals would
meet each day. These early capital markets were in coffee houses,
Masonic lodges or sometimes just in a particular street. People with
money were looking for a place to invest it and receive a return.
Businessmen were looking for money to be invested so that they could use
it within their company. Others were there to buy and sell and
hopefully make a profit.

These early gatherings, and the modern stock markets that they have become were all about one fundamental thing - the allocation of capital.

These days, allocating capital is not enough. Professional fund manager spend their lives trying to
make decisions that result in the efficient allocation of capital. But
over one hundred years ago, the simple allocation was enough.

These capital markets are not only about equity though. The
modern stock market that we think of is one in which investors buy and
sell part ownership of businesses. This part ownership might be simply
one share, or several percent of the company.

What about companies that do not want to sell their ownership
rights? These companies did, and can still, use a stock market for
raising debt capital. This is normally known as a bond market. Companies - and governments - can borrow money for short periods of
time to as long as twenty five years. They will set an interest rate to
be paid on the money at the outset and then redeem the debt in full at
the end of the predetermined term. In the meantime, investors and
traders can buy and sell part ownership of this debt in the market.

In our modern world, understanding the quality of this debt is an
industry in itself, one dominated by three major companies known as
stock or credit rating agencies.

Larger companies gravitate towards the money. This means that
locations in which it is easier to raise funds tend to get more funds to
raise and companies in need of them. It can be a self-fulfilling
prophecy.

Global companies will look very closely at a range of locations
for raising capital from stock market instruments to assess their
qualities. They will be looking at the regulatiory burden, ease of doing
business, costs to manage and more. These are the kinds of factors that determine whether or not a capital market is efficient.

Some organisations (like the Milken Institute - a think tank based in the United States) rate locations (countries) to
try and assess the best place for a company to raise capital. This
could easily be argued to be one of the fundamental tenets of
capitalism, so it is very important.

In recent years, the United Kingdom (2005) and Canada (2007 and
2008) have been rated the number one location for fund raising for
businesses.

To give an idea of the places that are viewed well, in 2005 the
Milken Institute rated the top 10 locations for accessibility of capital
for entrepreneurs as:

1. United Kingdom

2. Hong Kong

3. Singapore

4. United States

5. Sweden

6. Denmark

7. Australia

8. Norway

9. Finland

10. Canada

That might not have bee the kind of list you were expecting! The
Nordic nations tend to have reputations for high taxes, all encompassing
social security rights and socialism - but it seems that they can
allocate money as well. That particular survey was based on over 50
measures (things like the strength of the banking system and diversity
of financial markets).

It probably goes without saying that a capital market is based on capital.
While that may sound obvious, the high rates of borrowing by
individuals, corporations and local and national governments, may mean
that in years to come places like Wall Street and The City of London are
less attractive to companies.

Since the fast growing economies are currently Brazil, India and
China, it is possible that Hong Kong, Singapore or Shanghai may grow in
dominance in years to come. Who can say? It will largely be related to
their ability allocate capital!